240 Corporate Finance
Options traded on ACC stock, March 20, 2003 (Rs per share)
Stock price Rs 139
Exercise price Rs 135
Maturity date 24/04/2003
Call option premium Rs 5.15
Put option premium Rs 2.70
The underlying asset in the given case is a stock. Options are of two types: European and American.
European options can be exercised only on the maturity date whereas American options can be exercised any
time up to maturity. The given example is an American type option. The buyer of a call option on ACC stock
could have purchased it at Rs 135, any time before the maturity date. Likewise, the holder of a put option
could sell ACC stock at Rs 135 by exercising the option.
Options have premium value and intrinsic value. The premium value of the call option mentioned above
is Rs 5.15 and that of the put option is Rs 2.70. The premium is simply the market value of the contract, the
price at which buyers and sellers of the option are willing to enter into a contract. Each option contract is for
100 shares. Therefore, an investor would have to pay Rs 515 to buy a call option and Rs 270 to buy a put
option. The intrinsic value is the price an investor would pay for the option if it were to mature immediately.
Assume that you buy a call option on the ACC stock at Rs 5.15. If the price of the stock were to decline to Rs
132 you would not exercise the option because it is cheaper to buy in the market rather than exercise. So the
option expires worthless. In other words, the value of an option can be—at worst—zero. Suppose the price
increased to Rs 140. The intrinsic value of the option is Rs 5, the profit you make by exercising the option
and selling the share simultaneously in the open market. In general, the intrinsic value of a call option is the
maximum of zero and the difference between the current market price of the underlying asset and the option’s
exercise price.
The opposite is true of put options. They gain value when the price of the underlying asset decreases be-
cause the holder of the option can sell the asset at a higher price than the prevailing market price. The intrinsic
value of a put option is the maximum of zero and the difference between the put option’s exercise price and
the current market price of the underlying asset. An option is in-the-money if its intrinsic value is positive
and out-of-the money if its intrinsic value is negative. A call option is in-the-money if the price of the
underlying asset exceeds exercise price. The converse is true for a put option. An option is at-the-money
when the asset price and the strike price are equal. If the asset price is far above the exercise price for a call
option, the option is deep in-the-money. If the asset price is far below the exercise price for a call option, the
option is deep out-of-the-money. The converse is true for a put option. Assume that on January 6, 2003 you
purchased a call option to buy 100 shares of Hindustan Lever at a strike price of Rs 180. Each option has a
premium of Rs 5. The options expire on January 30, 2003. At the time of entering into the contract the buyer
has to pay a premium of Rs 5×100 for each contract. The value of the call option for various exercise prices is:
(in Rs)
Stock price Value of
Exercise price (spot price) Premium call option
180 170 5 –5
180 175 5 –5
180 180 5 –5
180 185 5 0
180 190 5 5
180 195 5 10